US Regulatory Research

US Regulatory Update

General

OFR Publishes its 2018 Annual Report

On 15 November, the Office of Financial Research (“OFR”) published its 2018 Annual Report to Congress, which assesses the state of the U.S. financial system and identifies changes in its systemwide risk levels and patterns. Key findings from the report include: (i) the risks to U.S. financial stability remain overall in a medium range; (ii) macroeconomic risks remain at a moderate level, though the OFR sees more risks to the outlook than in the previous year; (iii) market risks remain high, as stock prices remain historically high, and bond prices are more vulnerable to price declines than in the previous year because of the possibility that interest rates could rise quickly; (iv) credit risk is moderate, as nonfinancial corporate credit growth is robust, credit quality shows signs of weakening, and credit risk is rising with growth in leveraged lending; (v) solvency and leverage risks remain low under most conditions, as large banks and insurers hold capital well above regulatory minimum requirements, but a few U.S. global systemically important banks could fall below those minimums under severely adverse conditions; (vi) funding and liquidity conditions are generally good and continue to support corporate borrowing, as large banks’ funding and liquidity risks appear low; (vii) contagion risks are moderate, as risks to the financial system from the largest U.S. banks remain low, although derivatives exposures are still a source of contagion risk throughout the financial system; and (viii) cybersecurity and cryptocurrencies remain a key risk to the U.S. financial system.

U.S. Congress

Senate Judiciary Committee Holds Hearing on Bankruptcy Reform

On 13 November, the U.S. Senate Committee on the Judiciary held a hearing entitled “Big Bank Bankruptcy: 10 Years After Lehman Brothers.” Testifying at the hearing were: Donald Bernstein, Partner at Davis Polk & Wardwell LLP; Mark Roe, Professor of Law at Harvard Law School; and Stephen Hessler, Partner at Kirkland & Ellis LLP. The hearing principally focused on (i) the new Chapter 14 proposed to be added to the Bankruptcy Act, which would amend bankruptcy procedures for certain financial institutions, and (ii) Title II of Dodd-Frank, which provides a process to liquidate large financial companies on the verge of failing. Committee Chairman Chuck Grassley (R-IA) asked the panelists about how Chapter 14 would ensure that executives will not inappropriately funnel money to themselves prior to bankruptcy or use tax money to funnel money to themselves. Mr. Hessler answered that Dodd-Frank already prohibits taxpayer bailouts and that taxpayer money cannot be used to pay for bonuses of executives. Senator Chris Coons (D-DE) asked whether Chapter 14 would complement Title II, to which Mr. Bernstein responded that the Department of the Treasury recently reported that Chapter 14 and Title II can “coexist.” Professor Roe added that it is not clear whether Chapter 14 could work without having Title II, and vice versa. Senators Coons and John Cornyn (R-TX) asked about the inclusion of an involuntary petition option under Chapter 14 that would allow regulators to initiate bankruptcy proceedings. Professor Roe said it is important for regulators to have this option to put financial institutions on notice that regulators can forcefully file Chapter 14.

House Financial Services Committee Holds Hearing on Fed’s Supervision of the Financial System

On 14 November, the U.S. House Committee on Financial Services held a hearing entitled “Semi-Annual Testimony on the Federal Reserve’s Supervision and Regulation of the Financial System.” Randal Quarles, Vice Chairman for Supervision of the Board of Governors of the Federal Reserve System (“Fed”), provided testimony for the hearing. In his opening statement, Committee Chairman Jeb Hensarling (R-TX) stated that the Dodd-Frank Act significantly increased the scope of the Fed’s authority beyond its traditional monetary policy responsibilities and that it was “disconcerting” how the Fed could “functionally control” the largest financial institutions. Vice Chairman Quarles responded in his testimony by stating that the Fed is taking steps to tailor its regulatory framework to make it simpler and more efficient. He emphasized that firms should be scrutinized based on the risk that they pose. He noted two recent proposals issued by the Fed implementing the requirements under S. 2155, the Economic Growth, Regulatory Relief, and Consumer Protection Act, to align prudential standards to the risk posed by financial institutions. Quarles also stated that the Fed will soon finalize a set of measures to increase the transparency of its stress tests, which will include making public the models and losses that are expected due to different stressors so that banks can compare these scenarios with their own models. When questioned by Committee Chairman Hensarling and Rep. French Hill (R-AR) regarding H.R. 4790 and the simplification of the Volcker Rule, Quarles replied that without such legislation, it would be difficult to sustain an interagency agreement to enforce the harmonization of the Volcker Rule. When questioned by Rep. Andy Barr (R-KY) and Rep. Trey Hollingsworth (R-IN) regarding the omission of foreign banking organizations (“FBOs”) from the tailoring proposals, Quarles highlighted the importance of FBOs to the domestic economy and reassured the representatives that the Fed will implement a process to ensure that there is a level playing field for FBOs and domestic banks.

Senate Banking Committee Holds Hearing on Fed’s Supervision of the Financial System

On 15 November, the U.S. Senate Committee on Banking, Housing, and Urban Affairs held a hearing entitled “The Semi-Annual Testimony on the Federal Reserve’s Supervision and Regulation of the Financial System.” Fed Vice Chairman for Supervision Randal Quarles provided testimony for the hearing. In addition to what was discussed in the House Committee on Financial Services hearing, Quarles stated that the Fed’s agenda includes: (i) a joint agency examination of the community bank leverage ratio proposals in partnership with the Office of the Comptroller of the Currency (“OCC”) and Federal Deposit Insurance Corporation (“FDIC”), which he stated would be published “very soon”; and (ii) proposals for modernizing the resolution framework and tailoring of FBOs. When questioned by Sen. Bob Menendez (D-NJ) on the effects of the Fed’s recently proposed amendments to the liquidity rules, Quarles replied that the proposal would only result in a 2 to 2.5 percent reduction of liquidity in the financial system and that the proposal seeks only to tailor the burden of regulatory compliance with the risk posed by financial institutions and not to decrease the amount of liquidity in the market.

Senate Confirms New Fed Governor Bowman

On 15 November, the U.S. Senate confirmed, by a vote of 64 to 34, the nomination of Michelle Bowman to be a Member of the Board of Governors of the Fed.

SEC & Securities

SEC Commissioner Peirce Speaks on Regulatory Compliance

On 30 October, Commissioner Hester Peirce of the Securities and Exchange Commission (“SEC”) delivered remarks before the National Membership Conference of the National Society of Compliance Professionals in a speech entitled “Costume, Candy, and Compliance.” In her speech, Peirce suggested that the SEC consider alternative methods for addressing compliance infractions other than enforcement proceedings. Peirce believes that “a better approach is to build certain norms into the industry that foster compliance.” She acknowledged that a “subtle” approach does not work for those who are “not well-intentioned,” but she believes the majority of compliance professionals are “trying to do the right thing.” This is why, Peirce argues, the SEC should not target well-intentioned compliance professionals with enforcement actions but rather assist them in “understanding how the rules apply to the unique features of [their] firm[s].” In her opinion, enforcement actions against well-intentioned compliance professionals can have a “chilling effect” and adversely impact the compliance industry. However, Peirce emphasized the importance of firms’ cooperation with the SEC’s compliance staff because too often firms “drag their feet” or provide inaccurate information. While the SEC’s Division of Enforcement plays an important part in countering violations of the securities laws, Peirce argues that managers and employees at firms are the “first line of defense” against securities violations, followed by compliance officers.

FHFA Updates Progress on Single Security Initiative and Common Securitization Platform

On 13 November, the Federal Housing Finance Agency (“FHFA”) publishedAn Update on the Single Security Initiative (SSI) and the Common Securitization Platform (CSP) “detailing activity and progress on the development of the CSP and toward the launch of a single, common security called the Uniform Mortgage-Backed Security (UMBS).” According to the news release accompanying the Update, “Fannie Mae and Freddie Mac (the Enterprises) and their joint venture, Common Securitization Solutions (CSS), will implement the SSI and issue the first UMBS on June 3, 2019.”

IOSCO Issues a Report on Leverage

On 14 November, the Board of the International Organization of Securities Commissioners (“IOSCO”) issued a Consultation Paper entitled “Leverage,” which proposes a framework to evaluate leverage used by investment funds. The proposed framework contains a two-step process to achieve a “meaningful” and “consistent” analysis of global leverage. The first step “would use the measures of leverage identified and/or developed, with a view to identify and analyse funds that may pose a risk to financial stability.” The second step “would involve further analysis of this sub-set of funds.” The paper is in response to a request from the Financial Stability Board in its 2017 report, “Policy Recommendations to Address Structural Vulnerability from Asset Management.” Comments on the Consultation Paper are due by 1 February 2019.

SEC Staff Host a Roundtable on the Proxy Process

On 15 November, the SEC Staff hosted a roundtable on key aspects of the U.S. proxy system. The participants discussed a number of topics, including: (i) the proxy voting mechanics and technology, (ii) shareholder proposals and engagement; and (iii) the current and future landscape of proxy advisory firms. With regards to the proxy voting mechanics and technology, the participants generally agreed that the existing proxy voting system is inefficient, opaque, and inaccurate. A number of participants supported the adoption of a universal proxy ballot, which they say will help reduce shareholder confusion; some participants, however, warned that the details of a universal ballot, such as the order that the names of the contestants appear on the ballot, will be crucial to the success of such as system. The participants highlighted the SEC’s 2016 proposed rule on universal proxies as an option to consider. The participants also generally supported the adoption of an end-to-end vote confirmation process, which they argue would help ensure that there is not an undercounting or overcounting of votes. With regards to shareholder proposals and engagement, the main discussion point related to the submission threshold of shareholder proposals. Some participants supported retaining current levels to allow small investors the opportunity to participate in the process, while other participants argued that the submission threshold needed to be raised because certain shareholders would attempt to impose their personal policy priorities at the cost of the rest of the shareholders. The participants also discussed a number of issues relating to SEC staff guidance, such as the SEC Staff’s Legal Bulletin 14H, which narrowed the definition of a “direct conflict” with respect to Rule 14a-8(i)(9) under the Securities Exchange Act of 1934. With regards to the current and future landscape of proxy advisory firms, the participants discussed the state of “robo-votng” and whether market participants automatically rely on proxy firms' recommendations as the basis for casting their votes. While the market participants argued that the proxy firms' recommendations were being used to execute their own voting guidelines, the proxy advisory firms maintained that their recommendations do not form the basis for market participant’s voting decisions. Institutional Shareholder Services (“ISS”) claimed that 87 percent of their clients have customized preferences, and Glass Lewis claimed that 80 percent of their clients have customized preferences. Both ISS and Glass Lewis also countered criticisms that there was a conflict of interest in the advice they offered, with Glass Lewis stating that it does not offer consulting services and discloses all of its potential conflicts with its recommendations and ISS stating that it has kept its consulting services side of the business completely separate from its proxy advisory portion of the firm.

On 16 November, the SEC’s Division of Corporation Finance, Investment Management, and Trading and Division of Markets (“Divisions”) released a statement “[highlighting] several recent Commission enforcement actions involving the intersection of long-standing applications of our federal securities laws and new technologies.” The statement describes recent SEC activity in three areas: (i) offers and sales of digital asset securities, (ii) investment vehicles investing in digital asset securities, and (iii) trading of digital asset securities. The Divisions warned that “market participants must…adhere to our well-established and well-functioning federal securities law framework when dealing with technological innovations, regardless of whether the securities are issued in certificated form or using new technologies, such as blockchain.”

CFTC & Derivatives

CFTC Approves Final Rule Amending Uncleared Swap Margin Requirements

On 19 November, the Commodity Futures Trading Commission (“CFTC”) approved a final rule to amend its uncleared swap margin requirements for uncleared swaps for swap dealers and major swap participants that do not have a prudential regulator (“CFTC Margin Rule”), in light of certain rules recently and jointly adopted by the Fed, the OCC, and the FDIC regarding restrictions on certain qualified financial contracts (“QFC Rules”). Specifically, the final rule: (i) ensures that “master netting agreements of firms subject to the CFTC Margin Rule are not excluded from the definition of ‘eligible master netting agreement’ based solely on such agreements’ compliance with the QFC Rules”; and (ii) ensures that “any legacy uncleared swap . . . that is not now subject to the margin requirement of the CFTC Margin Rule will not become so subject if it is amended solely to comply with the QFC Rules.”

CFTC Chairman Giancarlo Speaks on Capitalism and Individual Liberty

On 12 November, CFTC Chairman Christopher Giancarlo delivered remarks before the Global Financial Leadership Conference in a speech entitled “Introduction: A Great American Institution.” In his speech, Chairman Giancarlo pointed out the importance of independent financial regulation to free-market capitalism and individual liberty, particularly at a “time of growing erosion of trust” and efforts “to increase political control over markets.” Giancarlo criticized politicians and governments who use the markets as tools to help drive social, political, and other governmental policies. He argued that prosperity depends on “open and competitive markets, combined, with free enterprise, personal choice, voluntary exchange and legal protection of person and property.” Further, Giancarlo said insulating financial regulation from political influence allows federal market regulators to focus on regulating in the best interest of the markets.

On 14 November, CFTC Director of Enforcement James McDonald delivered remarks before the NYU School of Law: Program on Corporate Compliance and Enforcement regarding the CFTC’s fiscal year (“FY”) 2018 priorities and initiative. In his speech, Director McDonald highlighted four key priorities: (i) preserving market integrity, where the CFTC’s Division of Enforcement (the “Division”) has focused on “detecting, investigating, and prosecuting misconduct that has the potential to undermine market integrity—misconduct like manipulation, spoofing, and disruptive trading”; (ii) protecting customers, where the Division has “aggressively prosecuted fraud in traditional areas, like precious metals, forex, and binary option” as well as in “new products or new technologies . . . like virtual currencies”; (iii) promoting individual accountability, where “more than two-thirds of [the CFTC’s] cases [in FY 2018] involve[ed] charges against individuals,” including charges against supervisors and controls persons such as “desk heads, CEOs, and a Chairman of the Board”; and (iv) enhancing coordination with other regulators and criminal authorities, where the Division has focused on “expand[ing] effort[s] to charge cases in parallel with our criminal law enforcement counterparts.” McDonald then described a number of initiatives the CFTC has recently launched to support these priorities, including: (i) initiatives improving the CFTC’s Market Surveillance Unit and increasing the CFTC’s use of data analytics; (ii) the creation of specialized task forces to address issues related to spoofing and manipulative trading, virtual currencies, insider trading, and anti-money laundering; and (iii) the launch of the cooperation and self-reporting program.

On 21 November, the Fed, FDIC, and OCC issued a joint proposal that would simplify the regulatory capital requirements for qualifying community banking organizations that opt into a community bank leverage ratio (“CBLR”) framework; the simplification is required by the Economic Growth, Regulatory Relief, and Consumer Protection Act. According to the agencies, the proposed CBLR framework is a “simple alternative method to measure capital adequacy” and would “provide material regulatory relief to qualifying community banking organizations.” Under the proposal, a qualifying community banking organization would be defined as a depository institution or depository institution holding company that meets the following criteria:

total consolidated assets of less than $10 billion;

total off-balance sheet exposures of 25 percent or less of total consolidated assets;

total trading assets and trading liabilities of five percent or less of the total consolidated assets;

mortgage servicing assets of less than 25 percent of CBLR tangible equity; and

deferred tax assets from temporary differences that the institution could not realize through net operating loss carrybacks, net of any related valuation allowances, of 25 percent or less of CBLR tangible equity.

Accordingly, qualifying community banking organizations “that elect to use the community bank leverage ratio and that maintain a community bank leverage ratio of greater than 9 percent would not be subject to other risk-based and leverage capital requirements and would be considered to have met the well capitalized ratio requirements for purposes of section 38 of the Federal Deposit Insurance Act.” Comments on the proposed rule are due 60 days after its publication in the Federal Register.

On 13 November, Fed Governor Lael Brainard delivered remarks at the Federal Reserve Bank of Philadelphia’s Fintech and the New Financial Landscape conference in a speech entitled “What Are WE Learning about Artificial Intelligence in Financial Services?” In her speech, Governor Brainard cautioned firms to be mindful of the risks associated with artificial intelligence and advised regulators to remain diligent in the quest to understand and regulate the use of artificial intelligence by firms. Brainard argued that the regulation of artificial intelligence risks should be designed in a way not to hinder innovation that may benefit small businesses and consumers. She suggested that supervisory guidance to firms must be read in the context of the “relative risks” of the artificial intelligence applications and that the “level of scrutiny” towards each artificial intelligence approach should be proportional to the potential risks of that approach, tool, model, or process.

FDIC Chairman McWilliams Discusses FinTech

On 13 November, FDIC Chairman Jelena McWilliams delivered remarks at the Federal Reserve Bank of Philadelphia’s Fintech and the New Financial Landscape conference. In her speech, Chairman McWilliams advocated for the cooperation of industry innovators and regulators to “increase the velocity of transformation” of FinTech and to ensure that “banks are safe and sound and consumers [are] sufficiently protected.” Chairman McWilliams noted that innovation is expanding access to banks for more customers and that new technology is enhancing the “customer experience, [lowering] transaction costs, and increase[ing] credit availability.” However, she points out that millions of Americans are not experiencing the benefits of FinTech because they are “unbanked” or “underbanked.” As a result, Chairman McWilliams argues, “It will be up to institutions to leverage technology and develop products to reach these customers.” She predicts that advancements in technology and data analytics will impact banking in four key ways: (i) “[d]ata analytics will improve lending and help banks develop new approaches to assess credit risk”; (ii) “[t]echnology will transform how banks identify customers and how they distinguish routine transactions from suspicious activity”; (iii) “[a]rtificial intelligence and machine learning will provide better opportunities to manage risk”; and (iv) advancements in technology will change the way regulators approach oversight. In closing, Chairman McWilliams urged the FDIC to increase its collaboration and partnership with the industry in order to avoid playing “catch-up” with technological advancements.

Comptroller Otting Discusses the Condition of the U.S. Banking System

On 14 November, Comptroller of the Currency Joseph M. Otting delivered remarks before the Special Seminar on International Finance in Tokyo, Japan. In his speech, Otting reminded the audience of the OCC’s July 2018 decision to begin accepting applications for national bank charters from nondepository FinTech companies engaged in the business of banking. He described the FinTech charter as a way to facilitate more choice for consumers and businesses while creating “greater opportunity for companies that want to provide banking services in America.” Otting pointed out that other charter options are available for FinTech companies, such as state banking charters and partnerships with other financial institutions, but he believes the option for a national bank charter “allows these companies to choose the best business model and regulatory structure for their business and strategic goals.” Regarding the U.S.’s dual banking system and the OCC’s role in regulating foreign banking organization branches and agencies, Otting said the OCC “strongly supports” the dual banking system and that the business decision of whether to operate under a state or federal license is a bank’s to make; however, he stressed that the OCC is “well positioned and qualified to provide effective and efficient supervision of federal branches of foreign banks operating in the United State because of its experience supervising the largest, most internationally active banks in the country.”

On 15 November, FDIC Chairman Jelena McWilliams delivered remarks before the Office of Financial Research and the University of Michigan's Center on Finance, Law, and Policy Fourth Annual Financial Stability Conference regarding the migration of financial activity from banks to nonbank institutions. In her speech, Chairman McWilliams noted that there has been a significant increase in nonbank institutions offering traditional banking services such as the origination of mortgages. She noted that “in 2009, nonbanks accounted for only 9 percent of the volume of mortgages originated by the top 25 originators, versus 44 percent in 2018.” She warned, however, that even though such services have migrated, “a portion of that risk remains with banks or could be transmitted back to the banking system through other channels.” For example, she noted that bank lending to nonbank financial companies has increased by 636 percent from 2010 to 2018. As a result, she urged regulators and policymakers to consider the risks and benefits of such migration of activity and to ensure that there is a framework that addresses the systemic risks that could arise from these changes.

Fed Vice Chairman for Supervision Quarles Discusses Stress Testing

On 16 November, Fed Vice Chairman for Supervision Randal Quarles delivered remarks at a Harvard Law School regarding Fed’s proposed stress capital buffer (“SCB”), which would replace the current fixed buffer requirement of 2.5 percent of risk-weighted assets with one based on each firm’s stress test results. Quarles highlighted three elements of the SCB that could benefit for further refinement: (i) “the volatility of stress test results,” (ii) “the sequencing of stress test results with capital plan submissions,” and (iii) “the post-stress leverage requirement.” Quarles said that he expects the Fed will adopt a final rule “in the near future” but that he expects that “the first SCB would not go into effect before 2020.”

Announcements

On 15 November, the Fed released a statement saying that next year it “will review the strategies, tools, and communication practices it uses to pursue its congressionally-assigned mandate of maximum employment and price stability.” The review will include “outreach to a broad range of interested stakeholders.” Fed Chairman Jerome Powell also said, “With labor market conditions close to maximum employment and inflation near our 2 percent objective, now is a good time to take stock of how we formulate, conduct, and communicate monetary policy.” The Fed said that at the end of the review process, the Fed will assess the information gathered during the year of review and report its findings.

· Dec. 3: U.S. Department of the Treasury, Federal Reserve, Federal Reserve Bank of New York, SEC, and CFTC will co-host the fourth annual conference on the evolving structure of the US treasury market.